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Why are investors funds tied up in covered interest arbitrage. (Can you explain in depth and...

Why are investors funds tied up in covered interest arbitrage. (Can you explain in depth and try to answer the question)

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Expert Solution

Explaination with examples:

What is Covered interest arbitrage: It is the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract. The logic of the term covered interest arbitrage becomes clear when it is bro- ken into two parts: “interest arbitrage” refers to the process of capitalizing on the difference between interest rates between two countries; “covered” refers to hedging your position against exchange rate risk.

Examples:

You desire to capitalize on relatively high rates of interest in the United Kingdom and have funds available for 90 days. The interest rate is certain; only the future exchange rate at which you will exchange pounds back to U.S. dollars is uncertain. You can use a forward sale of pounds to guarantee the rate at which you can exchange pounds for dollars at a future point in time. This actual strategy is as follows:

  1. On day 1, convert your U.S. dollars to pounds and set up a 90-day deposit account in a British bank. (for this period your funds are tied up)

  2. On day 1, engage in a forward contract to sell pounds 90 days forward.

  3. In 90 days when the deposit matures, convert the pounds to U.S. dollars at the rate that was agreed upon in the forward contract.

If the proceeds from engaging in covered interest arbitrage exceed the proceeds from investing in a domestic bank deposit, and assuming neither deposit is subject to default risk, covered interest arbitrage is feasible. The feasibility of covered interest arbitrage is based on the interest rate differential and the forward rate premium. To illustrate, consider the following numerical example:

Assume the following information:

  • You have $800,000 to invest.
  • The current spot rate of the pound is $1.60.

  • The 90-day forward rate of the pound is $1.60.

  • The 90-day interest rate in the United States is 2 percent.

  • The 90-day interest rate in the United Kingdom is 4 percent.

Based on this information, you should proceed as follows:

  1. On day 1, convert the $800,000 to £500,000 and deposit the £500,000 in a British bank.

  2. On day 1, sell £520,000 90 days forward. By the time the deposit matures, you will have £520,000 (including interest).

  3. In 90 days when the deposit matures, you can fulfill your forward contract obligation by converting your £520,000 into $832,000 (based on the forward contract rate of $1.60 per pound).

In the case of covered interest arbitrage, the funds are tied up for a period of time (90 days in our example). This strategy would not be advantageous if it earned 2 percent or less, since you could earn 2 percent on a domestic deposit. The term arbitrage here suggests that you can guarantee a return on your funds that exceeds the returns you could achieve domestically,

Hence, the investors funds are tied up in covered interest arbitrage.

*Note: The forward rate of a currency for a specified future date is determined by the interaction of demand for the contract (forward purchases) versus the supply (forward sales).


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